Tax system puts super funds at risk

Recent articles by
Jeremy Cooper
and Philip Baker (June 11-12) have made important points about the exposure of super funds to volatile assets such as shares.

Cooper makes some very good points about the risks that retirees are taking by investing in volatile assets, such as Australian shares.

His statistical analysis of the share market volatility that retirees should expect over their retirement is eye opening.

In addition, Baker, in his article about the protracted gestation of a retail bond market in Australia, quotes a well known statistic that Australian super funds have the highest exposure to shares of any of the OECD countries and he confirms that that is driven by super funds chasing the CGT discount on any gains and, more importantly, the imputation credits.

The articles highlighted a tension between prudent investment practice and tax-efficient investment in super funds. Prudent investment practice would suggest that because retirees do not have the ability to earn income to recoup any losses in their super, they should either avoid or limit their investment in risky assets, such as Australian shares.

Yet the tax system actively encourages retirees to invest in this asset class to get the after-tax results from refundable imputation credits.

This was identified in the Henry review when the panel said Australian shares in a super fund had a negative tax and was the most tax-preferred asset class when compared with owner-occupied housing, bank accounts and negatively geared investment outside a super fund.

In fact, the review recommended that super funds be taxed at a flat 7.5 per cent, even when paying a pension, on the basis that funds could invest in Australian shares to reduce the effective tax rate below that rate, again actively recommending investment in this risky type of asset.

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Two other examples where the system distorts prudent super fund investment practices are, first, regulatory concessions allowing contributors to sell their business premises into their self-managed super fund (SMSF) and, second, non-recourse borrowing.

The tax benefits of the first are well known: the contributor pays rent deductible at their tax rate to their super fund for their benefit and it is taxed in the fund at 15 per cent.

Any gains when the fund sells the property are taxed at either 10 per cent or not at all, depending on whether the fund is paying a pension.

Brilliant for tax, but prudent investment practice would suggest that assets funding retirement should be completely separate from business assets. After all, isn’t that what the majority of the 2500 pages of regulation around super are for?

With respect to non-recourse borrowing by SMSFs, one would have thought that negative gearing was optimised where the borrower has a high tax rate, so why borrow in the super fund that doesn’t? Our research has found that advisers are recommending that the super fund borrow rather than the high-tax-rate individual, because any gain will be taxed at either 10 per cent or, even better, not at all if the fund is in pension mode. Again, another example where tax distorts prudent investment practice of super funds.

Super funds are a very important source of capital for Australian companies, but maybe there is an argument that super funds should only be able to use credits up to their tax liability. However, that would mean people would invest outside super. A better alternative is to give tax preferences to less risky assets, such as bonds, to make them equally attractive for tax to super funds.